Contract Consequences

No doubt about it. Marketing hogs has changed drastically in the last few years. And nothing has highlighted this change more than the current drop in hog prices.When the hog market dipped to $35/cwt., one producer received $42/cwt. through a packer contract. His contract guaranteed a payment of $5 above a formula price based on cost of production.A group of producers in a southwest Iowa were getting

Karen McMahon | Sep 01, 1998

No doubt about it. Marketing hogs has changed drastically in the last few years. And nothing has highlighted this change more than the current drop in hog prices.

When the hog market dipped to $35/cwt., one producer received $42/cwt. through a packer contract. His contract guaranteed a payment of $5 above a formula price based on cost of production.

A group of producers in a southwest Iowa were getting $3-5/cwt. above cash prices, including group and quality premiums. And producers in a Kentucky group found a place to market their hogs, due in part to their group negotiations. (See stories starting on page 12.)

Now economists wonder how many producers actually receive the cash market price. It appears more producers regularly earn above the cash market than those receiving the cash price.

"We believe 57% of the hogs are sold on some kind of pre-arrangement," reports economist Glenn Grimes. That means the majority of U.S. hogs are sold on prices generally higher than the cash market price.

And few of the arrangements appear to be as lucrative or controversial as the packer contract. Producers on these contracts continue to receive prices well above breakeven. But those producers are also accruing debts, some reportedly into the six figures.

The amount of debt owed packers has created concern and rumors about packer viability and plant closings.

Contract Offerings Halt Grimes, through surveys conducted by the university, believes about 8.5% of the U.S. hogs are sold in written packer contracts with ledger accounts. These contracts involve a price window or a price based on cost of corn and soybean meal.

Last winter, producers scrambled for these packer contracts in anticipation of a poor hog market or short slaughter space. But today, virtually no packers are offering the contracts.

"It would be like shooting yourself in the foot," quips Mike Brumm, University of Nebraska swine extension specialist. The packers don't need to guarantee supply when an estimated 100 million hogs will enter slaughter plants this year.

The packer contracts guaranteeing profitable prices will make the hog glut easier for some producers.

"The packer contracts are performing for those who have them," reports Brian Buhr, agricultural economist, University of Minnesota. "If you look at some of the (packer contract) matrixes, they are paying out in the $40 range, which is a premium over $35-36 cash prices in the last six weeks." This is without quality premiums.

One producer who wishes to remain anonymous highlights the great run with these contracts. "We're making money big time, but sometime we're going to have to give it back," he reports. His contract is paying $42-43/cwt. in late August.

As this producer notes, the good run brings a big drawback. In most of the contracts, producers share the risk for the downside and the upside with the packer. This means, for example, when prices are $36/cwt. and the producer is guaranteed a floor price of $40/cwt., a ledger account begins. The $4/cwt. difference is noted in the ledger account, which the producer owes the packer. Some contracts call for the downside to be split, meaning only $2/cwt. is kept in the ledger account.

The same is true for prices above a certain price ceiling price of, say $50/cwt. If cash prices are $54/cwt., the producer receives $50/cwt. and $4 is noted in the ledger account. This is money the packer owes the producer. In some contracts, this amount is split and $2/cwt. is noted in the account.

The ledger accounts must be settled at the end of the contract period, which can run from 3-7 or more years. Some packer contracts require interest payments on the ledger accounts. They will also pay interest on money they owe the producer, usually prime rates plus 1%.

Hefty Ledger Accounts The down market is creating some hefty ledger accounts owed by the producer. One producer says his contract went from a positive $75,000 accumulated over two years to a negative $100,000. This swing occurred in seven months. The producer says this account is not included on his balance sheet and no cash changes hands. If he is in a negative position at the end of his contract period, he has the option to renew it for five years.

These packer contracts vary greatly, even contracts with the same packer. Many contracts do require that the ledger accounts be paid. Producers should clearly understand just exactly how the ledger account works because it could work against them.

"It may not be showing up on (balance sheets), but it is an accounts payable," says Steve Meyer, National Pork Producers Council economist. "It is another line of operating capital. You can get your current working capital ratios just as out of line there as you can borrowing from a bank.

"I don't know how producers are handling this," he adds. "That is the point - some people are not aware of how it should be handled."

Several contacts for this story also wondered if all bankers are aware of the accruing debt as well as the security positions for both packers and bankers. Some contracts state the packer holds first interest in the hogs, ahead of a lender.

Packer Risk Packers also face risk with contracts.

"On a down market with the packer contract, the pain of that falls back on the packer," Meyer says. "This is the reason the producers signed them in the first place."

While packer troubles due to contracts are not substantiated, rumors continue to swirl. And it is easy to see why.

"The question now is, if hog prices stay low and a packer has 60% of production in long-term contracts, for example, they are paying out a fair share of money over market price," suggests Minnesota's Buhr. "That affects their margins on wholesale price. The packer could face some working capital problems if it involves a large enough share of production."

Buhr says he has not heard of any problems with the packer contracts, though.

Helping keep the contracts in line are low grain prices. On the cost-of-production contracts, the payout to producers would be even higher if corn and soybean meal were higher priced, Buhr adds. This would make those ledger accounts even larger.

"I'm still amazed how lucky people have been with these contracts," he says. "Corn prices are very low in comparison to the five-year averages. There's no reason why we couldn't have $2.50 or $2.75 corn coupled with low hog prices."

The low feed prices have given all producers breathing space. Breakeven on finishing a 40-lb. feeder pig today runs in the upper-$30/cwt. range, Buhr says.

At these costs, some producers are still making money, especially those in the pre-arranged marketing agreements.

But it will be a wait-and-see situation for the overall success of the packer contracts. If producers and packers fair well through a long run of down prices, then there's no doubt, these contracts will be here to stay.